Compensating the Business Owner -- Part II

In part one, we examined the primary way to withdraw cash: your salary or owner's draw. In this, the second and final part, we'll discuss some other ways to use your business to improve your lifestyle.

As your business begins to take hold and your cash flow stabilizes, you may want to think about ways in which you can remove more money from the business in order to invest, to upgrade your lifestyle, or even to pursue another business venture.

Aside from your basic salary or owner's draw, there are a number of ways in which you can take advantage of favorable tax laws and use the business to maximize your wealth.

Corporate dividends. Dividends sound nice. You buy a stock, it pays dividends, and you're a happy investor. In fact, if you own a C corporation and it owns some GM or Disney or IBM, a whopping 70 percent of the dividends your company receives from those investments are excluded from taxation (as long as your company owns less than 50 percent of GM, Disney, or IBM, that is).

But for a privately held company, dividends are usually an expensive pain in the neck. When your closely held company pays dividends to you and your fellow shareholders, you must pay income tax on them, but your company does not enjoy a deduction for them. Hey, that's double taxation, you say! And you're right, it is!

On the other hand, your salary is subject to FICA taxes, whereas dividends are not. So, if your corporation's tax rate is 15 percent, it's worth it to pay at least some dividends in lieu of salary. An amount paid as dividends may be taxed twice (at the corporate tax rate, and then again at the individual tax rate), but your salary is essentially taxed twice also (at the combined FICA tax rate of 13.30 percent (15.30 after 2012) and again at the individual tax rate). The minute your company makes more than $50,000, it gets into the 25 percent corporate bracket and payroll taxes look cheap by comparison.

Also beware of the rule that if you don't pay all your profits out, your company could get socked with an accumulated earnings tax. A C corporation can usually retain up to $250,000 without adverse consequences, but a personal service corporation can only retain $150,000. Both types of entities may be permitted to retain amounts in excess of these limits if it can be demonstrated that the additional working capital meets the reasonable needs of the business; for example, if you need to retain cash to buy a new plant.

There is a happy medium to be struck in your dividend policy. If your firm is profitable, it's usually wise to declare a modest but regular dividend. Think of it as insurance against future audits.

Bonuses. In a C corporation, paying yourself a large, last-minute bonus at the end of a good year is not a habit you want to get into. A large end-of-year bonus will frequently be attacked by the IRS as a disguised dividend. Bonuses in a C corporation should be performance-based, with parameters established and documented in writing in advance.

On the other hand, if your business is organized as a sole proprietorship, partnership, LLC, or S corporation, it's not a bad idea to take a small owner's draw during the year, and then pay yourself a year-end bonus after you know how profitable your operation was that year. Regardless of what the payments are called, all the profits will be taxable to the owners, so the IRS has little concern about the timing of bonuses for these types of businesses.

Loans. What are loans doing in this column? Loans aren't compensation, are they? Well, the answer to that is that they often get reclassified as compensation (or, worse yet, as dividends) by the IRS, so you may as well think of them in that context.

The temptation for a small business owner to use his company as a bank is a mighty one, and one that should be mightily resisted. The owner of a closely held corporation is able to borrow from the company on favorable terms and repay when convenient, two considerations usually absent with outside lenders. Going the other way, an owner can also make loans to the company and earn a self-determined rate of interest. And the potential for the abuse of these powers is what inspires the IRS to increased vigilance in this area.

Loans, in order to elude reclassification, must be documented in writing, have a set repayment schedule, and carry an interest rate that can be considered consistent with the going rates charged by third parties. Otherwise, the IRS will generally treat the parties as having paid and received interest at the market rate on loans over $10,000. This means you'll pay tax on an amount of interest you never even received!

Basic fringe benefits. The value of so-called fringe benefits can enhance your total compensation enormously. Many have the advantage of being deductible to your business and not taxable to you.

The whole laundry list of fundamental fringe benefits—medical, dental, disability and group life coverage, dependent care and education assistance, business travel expense reimbursement, director liability insurance, employee discounts, spousal death benefits, group legal coverage, low interest loans, company cars, professional association dues and subscriptions (and maybe even use of the company gym)—is all very nice, but the real wealth-building benefits to small business owners come in two forms: retirement plans and life insurance.

Expenses paid by the business. Legitimate deductible expenses permitted for travel, meals, entertaining clients, automobile expenses, and the like, if properly claimed and documented, give an owner many advantages not enjoyed by regular employees. Considerable benefit can be gained through the use of deductions for company cars and expense accounts, as long as they are supported by extensive documentation that substantiates their legitimate business purpose.

But often, the business owner is tempted to go too far and gets into difficulty. In some cases the founder, failing to differentiate between himself and his business, plunders the business assets at will. After all, it's his business, so it's his money and he can spend it on himself if he likes, right? He's worked hard to build the business up and now he's going to reap the tax-free rewards. Forget compensation on which taxes must be paid, he thinks. He'll just pay his expenses directly out of the company. Or, if he's in a cash-heavy business, skim some off the top and not run it through the books.

An owner who uses his business to finance his personal living expenses or extravagant indulgences can expect frequent and costly visits from Uncle Sam's minions at the IRS. IRS agents can look at many sources of information, not just the books of the company, for proof of a business owner's spending habits. The newest wrinkle in audits is called a "lifestyle audit." The type of car you drive, the value of your residence, your travel patterns, and general spending habits are all grist for the IRS mill. If your "official" salary and other distributions from your business would not appear to support your lifestyle, you're a sitting duck for severe penalties.